April 8, 2010

Effect of New Information on Option

Filed under: Uncategorized — ktetaichinh @ 10:21 pm

Effect of New Information on Option

Prices Options, like all investments, are forward-looking, and they react to changes in investor expectations. This is another case where it is worth reiterating a concept: option prices change in response to changes in expectations. Any new information that changes expectations about the expected stock price or the range of outcomes for the stock price “should” change the price of the options on the stock. Should is the operative word here. In fact, if the options market is using statistical volatility as an anchor for options pricing, we’d expect cases where the options market does not react appropriately, and that presents opportunity for us. Simplistically, any news or information that increases the expected value of the stock should immediately move the stock price. This news can be a company release, economic data, earnings reports from a competitor, news reports of product scares, etc. Likewise, if these data change the uncertainty about the range of outcomes around the expected stock price, it should also change the value of the options. Ultimately, it is the combined impact of the information on both the underlying stock price and the uncertainty around the stock price that drive the changes in option prices. To people new to the options world, some of the price reactions can seem confusing or counterintuitive at first. However, using what we have learned about the inputs into option prices, we will see that these changes are sensible and easily understandable through the following examples. Big Announcements Imagine you find a great story stock. The rumor is that this company is going to be issuing a brand new product on the 20th of the month, so on the 19th, you load up on out-of-the-money call options hoping to take advantage of a strong price appreciation upon the formal product announcement. On the 19th, the stock

is trading at $45 and you buy your options struck at $50,

paying $3.69 for them. After the market closes on the

19th, the CEO goes on stage in California to introduce

the category killer: a beautiful new mobile phone that

is sleek, sexy, and functional. The press and analysts,

normally very hard to please, are singing the device’s

praises and the stock rises 5% in after hours trading.

What a smart investment, you congratulate yourself—

you’ll be able to sell the option tomorrow for much

more than you paid for it, or simply wait a while and let

the stock price exceed the strike and really rake it in!

Imagine your surprise when you check your prices the

next morning and find that the contracts you bought for

$3.69 the day before are trading for only $1.50.

What the heck happened?!

To understand this, we must go back to the concept of

volatility. In this case, the entire market expects

some announcement to be made on a certain date, so

investors begin buying options to grant them either

downside or upside exposure (or both) depending on

what they think the outcome will be. Volatility is the

commodity and it is in very high demand; as a result, its

value rises. In our example, I have assumed implied

volatilities reach 60% on the 19th. As soon as the

product announcement is made, the mystery is gone

and, because the range of outcomes for the stock price

after the announcement becomes much less uncertain,

the implied volatility suddenly declines. In our example,

I have assumed implied volatility falls to an annualized

rate of 25% on the 20th. Even though the price of the

stock rises to become closer to the strike, this effect is

swamped by the enormous drop in implied volatility.

The option’s value drops nearly 60% overnight.

Holiday Weekend “News”

It is March 20, 2008—the day before the Good Friday

holiday. Yesterday, you bought a call on XYZ stock

expiring at the end of March struck at $13 for $0.18

when the stock was trading at $12.75 per share. You

had expected some good news that would boost the

stock up above $13, but if the stock didn’t move, you

could sell the call back before it expired. When trading

starts on March 20, your call is priced at $0.17, but as

you check your screen through the day, you realize that

the value of your option is very quickly dropping. By the

end of the day, it is priced at $0.13—a loss of 24% in

one day. You cannot believe your eyes! Implied

volatility has stayed constant at an annual rate of 30%

and the stock has actually moved up a few pennies

from yesterday’s close. What the heck happened?!

As the clock ticks away over the weekend, if the stock

has not moved, the probability that the stock will make

it past the strike in the time allotted becomes smaller

and smaller (so the bet becomes worth less and less).

In a similar way, as an option nears expiration, all other

things held equal, there is less and less of a probability

that it will increase in value and wind up in the money.

Near-the-money options lose their time value very

quickly in the last few days before the contract expires.

In this case, there are only 11 days before the stock will

expire and over the holiday weekend, three of those

days will be burned up. The market begins pricing the

options as if the holiday has already happened—like

rust, time decay never sleeps.

In contrast to this example, the loss of time value for

extremely long-dated options (LEAPs) with most

of the contract time still in the future is almost

completely negligible. A two-year LEAP struck at $13

when the stock is trading at $12.75 is worth around

$2.68. Three days later, it is worth $2.67—a decrease

of only 0.4%.

Principle 8: Execute Strategies Efficiently

Understand How the Options Market Works—

Market Basics

Options, like stocks listed on Nasdaq, are considered

“over-the-counter” products. That means that a dealer

on a trading desk at an investment bank has agreed to

“make a market” in option contracts for certain stocks.

“Making a market” simply means that the dealer agrees

not to turn anyone away from trading in that security.

The market makers must post their prices publicly and

transact at the prices listed.

Another characteristic unique to options is that market

makers don’t want exposure to the underlying stocks.

Most hedge using the Black-Scholes model, selling stock

short to offset put positions and buying stock to offset

call positions, and most continually adjust stock positions

to keep the correct “hedge” to options ownership.

Now, imagine if you were making a market in the

options of hundreds of stocks, all of which had several

potentially market-moving news stories coming out

about them at any one time. It’s not hard to imagine

that one would start to worry that the people wanting

to trade with you might have an informational edge.

As a result, the dealers offer to buy at one price (the

bid) and sell at another (the ask or offer)—the so-called

bid-ask spread, on which they make their profit. The

more volatile and illiquid a stock, the greater chance of

“gapping” up or down (wherein the stock price opens a

trading session at a significantly different price than it

closed the previous session), the more difficult to hedge,

the wider the bid-ask spread.4

As with a car dealership, where you can spend $20,000

to buy a new car, drive it around the block once, and

find that the dealer will offer to buy it back for only

$13,000, options dealers want to make sure that if you

test drive one of their options for a few days, they will

realize a very healthy profit on the “round-trip” trade

when you sell it back to them.

Patience Is Key in Option Transactions

One way to reduce the impact of the bid-ask spread

is to recognize that the prices are the beginning

points for negotiation. You can imagine the midpoint

between the bid and asked price for the option as

the value of the option, and any difference between the

midpoint and the bid as the market maker’s “market.” The way to negotiate with a market maker is to enter

what is called a “limit order,” which is a price at which

you are willing to buy or sell the option. You can enter

that price and leave it in the market, and the market

maker may or may not execute the transaction. The

transaction could be executed immediately, or at some

time later in the day, so patience is key.

For example, if an option is Bid $1.00 and Ask $2.00,

the midpoint price is $1.50. The $1.00 the market maker

is willing to pay you has a $0.50 profit baked into

it, as does the $2.00 price the market maker wants

you to pay for the option. If you enter a price that you

are willing to pay of $1.70, you are offering a price

that will cut the market maker’s profit off of selling

you the option from $0.50 to $0.20 if the market maker

executes the transaction:

$2.00 – $1.70 = $0.30

This is known as trading $0.30 “inside their market.”

However, if the price for the stock takes a large swing

while your limit order is in place, you could wind

up getting “filled on your order” at the price you

want for the option, but at an implied volatility that is

significantly in the market maker’s advantage. The

resting limit order effect can be counteracted using

a “fill or kill” limit order, which gives the market

maker one shot at your order. There are more details

to execution, but the point is to pay attention to


The Iron Condor

No, this is not the villain from a Wild West fantasy

movie, it is the name of a very interesting and

attractive options strategy, especially in environments

when volatility is overvalued and the stocks

are fairly valued.5 As you can see from the payoff

diagram below, the iron condor is a combination of

four puts or calls at different strike prices. It may

take a minute to work through the logic of the final

payoff diagram, but if you trace carefully, you will

see that the resultant payoff diagram looks like a hat

with sloped sides and the opening

pointing downward.

What this shape tells us is that 1) we are short

volatility (i.e., a net seller of options) and 2) as long

as the underlying stock price does not move past

the $95 or $105 levels, we get to keep the entire premium

we received when we first entered into

the trade.

In economic terms, the fact that we are short

volatility shows that we think volatility is relatively

expensive (i.e., the outcome is more certain to us

than to the market). Also, the fact that we have set

up the position such that the stock price can move

around somewhat before we start to eat into the

cash flow from our option premiums means that we

recognize that the present stock price is about right,

but there may be some short-term swings from

which we want a bit of cushion.

Using the Morningstar Option Strategy Map, we

can envision a situation where we see high volatilities

(moving toward the right side of the graph)

and relatively correct values for the given stock (near

the middle of the chart), and we wind up in the

sector marked “Sell Neutral.”

Here we can see the probabilistic bets the seller of

an iron condor is making: maximum profits for the

most likely region of the curve and gradual degradation

of those profits if the stock moves too far

from its present market price. Notice also that the

iron condor caps our losses at a certain point,

so while we are selling options “naked,” our losses

are limited.

Principle 10: Manage Your Psychology with Your Portfolio

When it comes to investing, nothing beats discipline

and careful risk management. This is especially

true when investing in options, because they offer a

huge amount of potential leverage (i.e., one can

buy the right to a large portfolio with a comparatively

small initial cash outlay). Leverage means that

both risks and rewards are amplified, so the

unprepared often find themselves surprised and

disappointed when the market turns against them.

Here are a few simple rules to lay the groundwork

necessary to prudently build wealth using options.

Implied Versus Realized Volatility

Let’s return to our graphical interpretation one more

time to understand how implied volatility compares

with realized volatility, and thereby how implied

volatility turns into cash flow.

The longer the time period, the further the stock can

be expected to move away from its current price.

As an option has a longer time period to expiration,

the probability distribution gets fatter, and, therefore,

the upside or downside becomes more valuable, just

as we discussed above for increased implied

volatility. Reversing that logic, if time passes and the

stock price doesn’t move, the option value falls

because it has less time to expiration and less time

for the stock to move. This decay is depicted below:

The movement of the stock is realized volatility. So,

if we sell options and the stock price doesn’t move

and the option price falls, we realize income because

implied volatility exceeded realized volatility.

We can see that large stock movements in either

direction by expiration would mean the options were

undervalued, or realized volatility exceeded implied.

In the figure below, the difference between the

stock price at expiration and the strike price is far

above the value of the option at the beginning of thetime period. If the stock price moves by expiration

by more than the option price at the beginning of

the time period, we can say that realized volatility

exceeds implied volatility

It is also possible to sell and buy combinations of

options on a continuous basis as the stock price

moves to capture as much of the volatility difference

between implied and realized volatility as possible,

but understanding the concept of implied versus

realized is sufficient.

The point is, implied versus realized volatility is the

measure of returns to options, and unlike stock

prices, volatility cannot rise indefinitely or stock

prices would all swing between zero and infinity.

Similarly, volatility could never fall to zero or stock

prices would become perfectly stable. Volatility is

mean-reverting, and, over time, the long-term return

to implied volatility will be limited to the spread

between implied and realized volatility. Given that

selling options has some of the characteristics of

an insurance product, one would expect a slight

premium to accrue to the options seller. Anecdotal

data support this slight premium to the option seller

over time, although the data sets available don’t

include the crash of 1987, which may significantly

bias the data.


Think of this distinction in terms of Las Vegas. The

casinos make sure they have a statistical “edge” (i.e.,

will end up making money in the long run) before

they allow players to place bets. Going to Las Vegas

as a player is gambling because there is no expectation

that a player can win over the house over the

long run. Contrast this example with buying stock in

a casino that owns the games and has the edge on

the gamblers. Because the casino can reasonably

be expected to win, a bet on a casino is investing. In

fact, regardless of the game, each time the casino

takes a gambler’s bet, the casino has a fairly high

chance of losing on any individual bet. However,

each time the casino puts its capital at risk, it is

making an investment because it expects to win on

average over time.

Call Example

A real-life example that can represent the value of a

call option is that of volunteering as an advisor for a

political campaign. For a limited period of time, you

pay for the option by working on the campaign,

becoming known and respected by the politician

seeking office. If the candidate wins, you could have

a large upside through an appointment to a political

position. However, if the candidate loses, your

downside is limited to your efforts on the campaign.

Put Example

A real-world example of buying a put option is

purchasing insurance, say on your car, for a year. If

your car is damaged in an accident during that year,

the insurance must pay you the difference between

the value of your car and the post-accident value,

which is either the cost to repair the car, or the value

of the car itself in the event that the car is totally

destroyed. However, if the car makes it through the

year unscathed, your losses are limited to the cost of

the insurance.

A Stock Is a Call Option

To bolster the intuition of call options, it can be

helpful to consider the risk breakdown between

stocks and bonds. Investors tailor their risk and

return preferences by purchasing a mix of stocks and

bonds. In this way, the typical individual investor’s

portfolio is already full of options. Purchasing a

common stock is simply purchasing a call option on

the value of a business. A stock is just the upside

on the business above the value of the debt. The

stockholder gets the uncertain cash flows of the

value of the company above the value of the debt. If

the company goes bankrupt, the stockholder owes

nothing, and the bondholder takes any loss in the

value of the company below the face value of the

debt. If the company grows in value, the bondholder

captures none of the upside above the value of the

bonds and the stockholder captures all of the upside

to the value of the company.


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